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Author: RalphCramden Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 10551  
Subject: Re: Do diversification & liquidity harm economy? Date: 10/31/2002 3:33 PM
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Answer #1:
If EVERYBODY just blindly invested in S&P500 index funds no matter what else was going on, then this would become a problem. Since everybody is now investing mechanically, a company like S&P which makes its money off selling analysis would no longer have the money to look carefully at what was going on with the S&P500. Presumably long before things got to that point, they would convert the S&P500 to a mutual fund and stop telling people what they were buying and selling (moving into the index and moving out of the index) as they did it. If you think about it, the S&P500 is like a very simple mutual fund whose charter is to stay proportionately invested in 500 "big" "important" companies, with S&P deciding what "big" and "important" mean. If everybody invested in index funds, S&P would need to convert that popularity into an income stream by turing it into a managed fund.

Answer #2:
There are ALWAYS people investing using stupid strategies. They don't make as much money as people using smart strategies. In the short run things might work out for them. But in the long run, there is a tendency to weed out stupid strategies in a darwinian sense, essentially the stupid investors get their money eaten by the more successful investors. As more and more people invest in S&P index funds, there become more and more unfunded other opportunities. Those other opportunities have to give CAPITAL increasingly attractive terms to, well, attract CAPITAL. For example, companies doing IPOs will have to sell a larger % equity in their enterprise to raise a given amount of capital, so the people buying IPOs have an easier time making money on their investments since they own a greater share of the future earnings of the company. As these non-index companies increase the attractiveness of the terms on which they try to raise capital, people taking advantage of this will make more money than index fund investors. Smart people will see this soon and quickly and will move smart money towards the opportunity. Less smart people will eventually see this as well, and index investing will lose market share.

The REAL Answer:
The market is efficient because there are thousands of smart people constantly mining the data looking for tiny inefficiencies that they can exploit. Whatever course "most" people take, the fact that most are taking it opens up inefficiencies for these smart people to find. You DO NOT need to worry that your particular strategy is going to hurt the economy. On the contrary, you should be worried that your particular strategy is not going to work very well for you. The market, the "invisible hand," will take care of the big picture for you. As long as you are investing your money in a way which gives you a high return, you are virtually by definition helping the economy as a whole: you have moved your capital to a place where it can do a lot of good. If index funds work to do that for a while, then its a darn good thing for the economy that people recognize this and put their money in those funds. The information that index funds is a good way to invest is equivalent to the information that companies whose costs of raising capital is lowered by being in the index are, in general, doing a darn good job using that capital efficiently to create returns.

Its always harder to debunk a particular "perpetual motion machine" invention than to simply know that perpetual motion machines are all garbage (do not work). It is the same with analyzing the efficiency of a capital market. The details are complicated, but the overall picture is that people/strategies that do not put their investments in useful places are constantly being pressured out of the market by their lower gains or higher losses.

To the moon,
Ralph
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